Since I track the Nairobi Stock Exchange closely most of my friends and family constantly ask me; ‘which stock is hot? , where can I double my money fast? , Financials or industrials. I usually have one response prepared for these type of queries – that depends. I am sure these questions linger on several investors’ mind but the fact of the matter is; “You have to analyze each investment in terms of how it will affect the whole of portfolio of investments.”
This is known as the Modern portfolio theory (MPT) – MPT is a theoretical approach of investing where the investor tries to maximize the portfolio’s expected rate of return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully selecting the proportions of various assets – Asset Allocation.
Diversification is key in the modern portfolio theory – because it is rather obvious that not all businesses perform the same all time hence avoiding high volatility on the portfolio value. By building a portfolio consisting of uncorrelated investments, the investor actively reduces the risk of loss therefore maximizing returns.
This is known as the Modern portfolio theory (MPT) – MPT is a theoretical approach of investing where the investor tries to maximize the portfolio’s expected rate of return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully selecting the proportions of various assets – Asset Allocation.
Diversification is key in the modern portfolio theory – because it is rather obvious that not all businesses perform the same all time hence avoiding high volatility on the portfolio value. By building a portfolio consisting of uncorrelated investments, the investor actively reduces the risk of loss therefore maximizing returns.
The Investment Policy Statement (IPS)
Before constructing your portfolio, one should have a master plan that can be used even when you are not there – the Investment Policy Statement (IPS). The IPS is more or less a blueprint to your investments. It mainly covers the type of risk the investor is willing to assume, the investment objectives/goals, constraints and incorporates all this information when determining the nature of investments you wish to get involved in;
- Objectives – What are your goals in investing? When do you wish to retire? How much will you need to take your 2 year old to university when the time comes? Every investor should have a goal that he/she is aiming at.
- Time horizon – How long do you wish to hold an investment? Warren E. Buffet’s preferred time horizon if ‘Holding Forever’ – this may not be applicable to all investors but the point is that investments take time to bear fruit i.e. the snowball effect
- Risk – Not all investors can assume the same type of risk; young investors like us can assume more risk since we have the time to recover if we lose but older folks can’t afford to assume the same level of risk e.g. young lads generally allocate a good chunk of their portfolio to stocks while risk averse investors prefer bonds and cash.
- Investment Constraints – Liquidity needs, legal and regulatory issues, tax issues, unique needs and preferences – all of these must be incorporated inside the IPS
When you have built your Investment Policy Statement, you may then head to start some stock picking and you can easily read the 10 commandments of stock picking and go ahead.
Anthony Kahonge Mwangi is An Investment Researcher, Blogger and Freelancer. He blogs at Invest in Kenya